What is Universal Life Insurance? Pros and Cons

Universal life insurance offers lifelong coverage, provides flexibility when it comes to paying premiums and choices for how the policy’s cash value is invested. A standard universal life insurance policy’s cash value grows according to the performance of the insurer’s portfolio and can be used to pay premiums.

Variable and indexed universal life insurance give you options for how to invest the cash value. Universal life insurance is often compared to whole life insurance, which offers lifelong coverage but is less expensive and has more options.

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How does universal life insurance work?

Universal life insurance is a form of permanent insurance, meaning coverage can last for your lifetime if you pay your premiums. This is different from term life insurance, which only covers you for a set period, such as 10 or 20 years. Both individuals and employers can buy universal life insurance.

Cash value and premium payments

Universal life insurance has a cash value component that is separate from the death benefit. Each time you make a premium payment, a portion is put toward the cost of insurance (such as administrative fees and the death benefit) and the rest becomes part of the cash value. The cash value is guaranteed to grow at a minimum annual interest rate but may grow faster, depending on the company's market performance.

A universal life insurance policy's cash value can be used as:

A universal life insurance policy's premiums are split between the cost of coverage and the cash value. So, you can choose how much to pay within the minimum and maximum premium amounts. Many people choose to pay the maximum for the first several years of coverage. That way, it builds a large cash value, which can be used to pay premiums later on.

Running out of cash value can be particularly bad if your insurance cost increases. The cost of insurance can be the same for the life of the policy, but this isn't typical. Usually, there's a minimum and maximum cost, and your minimum premium will increase significantly as you get older. If this happens when your cash value is depleted and you're living on a fixed income, you may be stuck. Plus, your policy will lapse, meaning you'll lose your coverage. This is why it's incredibly important to keep close track of the cash value if you use it to pay premiums.

When shopping for coverage, make sure to note the difference between the guaranteed performance of a policy and the projected performance. The guaranteed performance indicates the worst-case scenario of minimum returns and maximum fees.

What is the maturity date in life insurance?

Universal life insurance policies mature when you reach a certain age (often 85 to 121). Generally, when a policy reaches its maturity date, you receive a payment and the coverage ends. Depending on the policy, the payment might be the death benefit or a specified amount, but it's usually equal to the policy's cash value.

This can be a problem if you live past the maturity date and have used most of the cash value to pay premiums. You can end up with no coverage and little money returned to you. So you should choose a policy with a maturity date that you're comfortable with, given your reason for getting the coverage. For example, if you want to prevent your family from paying inheritance taxes when you die, you should set a very high age for the maturity date.

Should you choose universal life insurance or whole life insurance?

Whole life and universal life insurance policies are both forms of permanent coverage. The primary differences are that the cash value for whole life insurance grows at a guaranteed interest rate, and premiums are always the same. This can be both an advantage and a disadvantage.

Universal life insurance has a greater upside potential. When the company's portfolio does well, the cash value grows at a higher rate. But when the company performs poorly, the interest rate would be lower for a universal policy than a whole life insurance policy.

Similarly, when the company performs poorly (usually when interest rates are low in the market) or you get older, they're more likely to increase the cost. Because whole life insurance premiums are steady, you’ll always know how much you'll pay.

Since the company guarantees a lower interest rate and offers a range of premiums, universal life policies are typically less expensive than whole life policies. This is a good consideration if you want permanent coverage with lower premiums. But if you only need coverage for a particular period, term life insurance may be better, because permanent policies will have much higher quotes.

How does indexed universal life insurance work?

Indexed universal life insurance has many of the same characteristics of a standard universal life insurance policy, except that the cash value's growth is tied to the performance of an index. Each company has its own selection of indexes available, and you may even be able to choose more than one. Some of the indexes most commonly offered are the S&P 500, NASDAQ 100 and Russell 2000. Performance is usually measured excluding dividends.

With indexed universal life insurance, you can often invest the cash value in a fixed interest rate account and an account tied to index performance. You tell the company the percentage of the cash value that should go into each investment, and they keep track of the performance. The fixed interest rate investment is lower risk and carries a higher guaranteed minimum return. The index-tracking investment has higher potential returns but a lower guaranteed interest rate.

When a policy's cash value growth is tied to an index, there are a few restrictions you should be aware of:

Pros and cons of indexed universal life insurance

Indexed universal life insurance offers greater control over your policy's cash value growth. You're not relying on a company’s performance. But the guaranteed minimum interest rate is typically lower than you'd get with a standard universal policy. And the company can cap your participation rate. You also face the same risks of a standard policy, because your cost of coverage can increase.

With an indexed universal life insurance policy, you should also know how the company calculates your base cash value. Because you're not actually invested in the index, the insurance company determines your return for a given period by multiplying your base cash value by the index's performance. If, for example, you pay a portion of premiums with your cash value, you want the base cash value to be measured pre-deduction. This way, a larger amount of money is multiplied by the index's rate of return, and your cash value grows faster.

Variable universal life insurance

Variable universal life insurance is very similar to an indexed universal policy. The primary difference is that you invest the cash value in grouped investments similar to mutual funds. You'll receive a list of potential investments, along with their performance history and fees. You can choose how much of the cash value is invested in each.

Pros and cons of variable universal life insurance

Each variable universal life insurance investment has management fees. The management and administrative fees for variable universal policies are typically higher than for other universal life insurance policies. So, even if you choose great investments, the fees can significantly eat into your returns.

Guaranteed universal life insurance

Guaranteed universal life insurance is a policy that won't lapse if the cash value is zero. It can essentially behave as a term life insurance policy, with the term ending when the policy matures, whether that's at age 90, 100 or 121.

Because there's very little or no cash value component, guaranteed universal life insurance is the best way to get the lowest quotes for permanent coverage. The cost of coverage is much lower than for a standard universal life insurance, and premiums are usually always the same.